Options Basics: Why Use Options?
  1. Options Basics: Introduction
  2. Options Basics: What Are Options?
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types Of Options
  6. Options Basics: How To Read An Options Table
  7. Options Basics: Conclusion

Options Basics: Why Use Options?

There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way. (For more on this, see Married Puts: A Protective Relationship and A Beginner's Guide To Hedging.)

A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company. (To learn more, see The "True" Cost Of Stock Options.)

Options Basics: How Options Work

  1. Options Basics: Introduction
  2. Options Basics: What Are Options?
  3. Options Basics: Why Use Options?
  4. Options Basics: How Options Work
  5. Options Basics: Types Of Options
  6. Options Basics: How To Read An Options Table
  7. Options Basics: Conclusion
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  3. Call On A Put

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  4. Exotic Option

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RELATED FAQS
  1. Why are options very active when they are at the money?

    Stock options, whether they are put or call options, can become very active when they are at the money. In the money options ... Read Answer >>
  2. How can I use equity options to protect my stock portfolio from downturns?

    Learn about stock options, how to use them to hedge stock positions and how they could help to protect stock portfolios from ... Read Answer >>
  3. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
  4. What do the phrases "sell to open", "buy to close", "buy to open", and "sell to close" ...

    The confusing terminology mentioned in the question deals with entering and exiting option orders. In review, there are two ... Read Answer >>
  5. How do speculators profit from options?

    As a quick summary, options are financial derivatives that give their holders the right to buy or sell a specific asset by ... Read Answer >>
  6. Do options make more sense during bull or bear markets?

    Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>

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